Who Is Afraid of High-Frequency Trading?

Apr 4 2014 | 8:21am ET

By Irene Aldridge
Managing Director, ABLE Alpha Trading

The equity markets deregulated, the cartels at exchanges went away and now high-frequency trading has taken the lead in placing orders manually. So who is it that is so upset about more liquidity, more transparency and lower spreads that high-frequency trading has shown to bring to the markets? Retail and institutional clients alike benefit from lower spreads and lower latency, and they enjoy real-time information on the most current prices. It’s the brokers that just don’t have the ability anymore to markup trades or charge the fees they once did. Their capacity to intermediate the markets has been eroded by high-frequency trading.

High-frequency trading is a computerized way to trade. Previously, brokers commanded huge salaries and bonuses for just taking client calls and recording their orders on a piece of paper. Some brokers also bet their clients’ money on where they thought the market was going, often without informing their clients. Finally, brokers operated under a complete shroud of inaccessibility; indeed, the only information their clients had about the prices they received were the four quotes published in the next day’s newspapers: open, high, low and close. As long as the price delivered by the broker fell within the high-low range, investors had no recourse to ascertain whether their broker really bought at the highest price, or whether he bought at the lowest price, kept the high-low difference to himself, and reported the high price to the investor.

High-frequency trading does away with all that.

With HFT, prices are completely transparent: all prices are instantaneously publicly available (BATS was a pioneer in disseminating their real-time tick data free of charge to the markets). Sophisticated algorithms successfully replace broker’s guesses as to where the markets are going. There is simply no need for many of the brokers anymore – the computers have effectively taken over, providing:

  • Lower costs to investors (1 computer can cost as little as $500/year vs $500,000+ for a broker)
  • Sophisticated science-driven HFT execution of orders trumps random guesses of individuals
  • Fast and effective HFT market-making strategies instantaneously identify shortages of liquidity and fill in the gaps
  • Numerous other benefits

Still, some people think that the fast technology that HFTs deploy is unfair to other participants in the market. Here is why the opposition to HFT on this topic is misguided.

Front-running, for example, is often cited as the worst of all HFT evils. Front-running refers to an activity where a market participant is aware of someone else placing an order, and is placing the same-sided order ahead of the other participant’s order. For example, if you know that Mrs. Smith is placing a market order to buy 1,000 shares, and if you have faster technology than Mrs. Smith, then you can hypothetically place a market buy order ahead of Mrs. Smith, potentially eroding liquidity available to her, thereby forcing Mrs. Smith to buy at a higher price.

The interesting fact that many HFT critics do not take into the account is that most markets in the world are presently anonymous, that is, no exchange displays the names of traders, or announces their orders or trades ahead of the order execution. The only people who may possibly know of incoming Mrs. Smith’ orders are, ironically, Mrs. Smith’ brokers. And they are the only ones who are capable of and do front-run Mrs. Smith’ orders in a practice now known as “pre-hedging."

There is really no reason for investors to listen to anti-HFT misinformation from brokers who demand outrageous fees, and who by and large now themselves rely on high-frequency trading technology to execute orders and make predictions. After all, should a phone call to a broker really cost you hundreds of dollars?

Irene Aldridge is a Managing Director at ABLE Alpha Trading, LTD., in New York. She is also the author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems, 2nd ed. (Wiley, 2013)

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